The purchase of a home is typically the largest investment that a person makes. Because of the amount of money required to purchase a home, most home buyers do not have sufficient assets to purchase a home outright on a cash basis. In addition, buyers who have already purchased a home may wish to refinance their home. Refinancing refers to the process of paying off one loan with the proceeds from a new loan using the same property as security for the repayment obligation. For the homeowner, the purpose of refinancing is usually to obtain a lower interest rate and/or to obtain cash for other purposes by reducing equity in the home. Therefore, potential homebuyers consult lenders such as banks, credit unions, mortgage companies, savings and loan institutions, state and local housing finance agencies, and so on, to obtain the funds necessary to purchase or refinance their homes. These lenders offer mortgage products to potential home buyers. A mortgage commits the lender (mortgagee) to provide loan funds sufficient for the borrower (mortgagor) to purchase the home. In exchange for the loan funds, the borrower commits to repay the loan funds by way of a series of loan payments. If the borrower fails to repay the loan funds, the lender has a legal claim against the home which allows the lender to sell the property and use the proceeds to pay off the loan balance (foreclosure). The lenders who make (originate and fund) mortgage loans directly to home buyers comprise the “primary mortgage market.”
When a mortgage is made in the primary mortgage market, the lender can: (i) hold the loan as an investment in its portfolio; or (ii) sell the loan to investors in the “secondary mortgage market” (e.g., pension funds, insurance companies, securities dealers, financial institutions and various other investors) to replenish its supply of funds. The loan may be sold alone, or in packages of other similar loans, for cash or in exchange for mortgage backed securities which provide lenders with a liquid asset to hold or sell to the secondary market. By choosing to sell its mortgage loans to the secondary mortgage market for cash, or by selling the mortgage backed securities, lenders get a new supply of funds to make more home mortgage loans, thereby assuring home buyers a continual supply of mortgage credit.
When a prospective borrower (or applicant, mortgagor) submits an application for a mortgage loan to a lender in the primary mortgage market the lender typically, at the borrower's election, will commit to hold (or lock) the interest rate for a period of time required to perform loan processing steps and close the loan. The lock guarantees that the interest rate will not increase during this period, but also restricts the interest rate from decreasing even if the secondary market interest rates decrease. Upon entering this lock agreement with the borrower, the lender becomes subject to price risk (i.e., the risk that secondary market interest rates will change) and volume risk (i.e., the risk that the locked loan will not result in a closed loan within the specified lock period).
To protect itself from interest rate fluctuation during the interim between when a borrower locks in and when the lender can sell the closed loan into the secondary market, a lender will enter into a hedge transaction. One such transaction is a forward commitment. A lender commits to sell a loan with a specified product and specified interest rate within a specified period to a secondary market purchaser. In exchange, the secondary market purchaser commits to pay the lender a specified price for the closed loan within a particular period of time.
In a forward commitment, the lender/seller locks in a price for the sale of the loan(s) at the time of commitment and has until the commitment expiration date to deliver the loan(s) to the purchaser. A forward commitment enables a lender/seller to reduce or eliminate interest rate risk. Without a forward commitment, if interest rates increase, the loan will be less valuable when sold into the secondary market. Conversely, if interest rates were to fall, the lender may benefit because a loan with a higher interest rate is more valuable when sold into the secondary market.
A forward commitment may be a cash commitment, i.e., an agreement in which the mortgage purchaser agrees to buy mortgages from mortgage sellers (e.g., lenders) in exchange for a specified price in cash. Typically, a cash commitment agreement specifies the type of mortgage(s) the seller plans to deliver, the unpaid balance of the loan(s) the seller plans to deliver, the amount of time the seller has to make delivery, the price the mortgage purchaser will pay the seller for the loan(s), and so on.
One type of forward commitment is a mandatory commitment. In a mandatory commitment, the lender/seller must deliver a committed unpaid balance of loan(s) by a designated delivery date. If the lender/seller does not deliver the committed unpaid balance, however, the lender/seller will incur a pair-off fee (for under deliveries) or an over-delivery fee. As such, mandatory commitments provide the lender/seller with protection against price risk but do not provide protection against volume risk.
Another type of forward commitment is a best efforts commitment. Best efforts commitments help lenders/sellers manage their price risk as well as the pair-off risk (or volume risk) by shifting the risk of pipeline fallout to the purchaser of the loan(s). Pipeline fallout occurs when a loan does not close within the specified time committed and therefore will not be available for sale to the investor. A best efforts commitment allows a lender/seller to get a price at commitment for a loan transaction and not be penalized or charged a fee if the loan does not close or “falls-out” of their pipeline. Only when a loan closes is the lender/seller required to deliver the loan to the purchaser.
As mentioned, a forward commitment typically involves a time delay between the commitment to sell the loan and the delivery date for the loan. During the time period between the commitment to sell the loan and the actual delivery of the loan, it is possible that changes may be made to the loan level data (e.g., loan characteristics) for the loan. Changes in loan level data may result from, for example, further negotiations between a borrower and a′ lender. A secondary mortgage market purchaser, however, may not become aware of the change until the loan is actually delivered by the lender. Certain changes to the loan level data may cause the secondary mortgage market purchaser to charge the lender a price adjustment for the sale of the loan or to reject the loan as being ineligible when the loan is delivered.